Laura Martin Real Options And The Cable Industry Harvard Case Solution & Analysis

Laura Martin Real Options And The Cable Industry Case Study Solution

A higher beta also suggests that the financial and business risk of Cox Communications is higher and vice versa, when it is compared with its closest competitor.The reason behind such differences is the size of different companies and the confidence level of investors in the securities of both companies.

At last, the reason behind the difference between two betas is the nature of business model and nature of the model used for the calculation of beta for Cox Communications.

Table 1.2

Ticker   Cox communication
Time Period 01/03/1995 - 06/30/1999
Coefficient of Determination (R2) 0.245
Regression F statistic 3.99 (p-value = 0.007)
Factor Loading Standard Error t-stat p-value 95% Confidence Interval
Market (Bmkt) 1.04 0.378 2.76 0.008 0.283...1.803
Size (Bsmb) 0.52 0.451 1.16 0.252 -0.384...1.431
Value (Bhml) 0.06 0.623 0.098 0.922 -1.191...1.314
Momentum (Bmom) 0.29 0.434 0.669 0.507 -0.582...1.163
Alpha (α) 122.25 bps 0.014 0.864 0.392 -1.62%...4.07%
Beta equity of Cox Communication 1.08

The BSOP Model for Option Pricing:

There are few limitations in a Black Sholes Model for option pricing in which any further alterations of use of any unrealistic further results in inappropriate values are on top from black Scholes model. It is used for European style call options, which means that shares can only be excised at maturity. The implied volatility from the call options will be taken from European options, which will not be suitable option under consideration or it might not reflect the proper results.

Furthermore,this model assumes that volatility will remain constant, risk free rate will also remain constant, and the Model assumes the market is efficient and stock and share options of markets are perfectly liquid.  The assumptions used by Martin in the valuation of Stealth tier are described below:

  1. First is the proxy value used for channel, which may not remain same in future because prices are subjected to changes
  2. Secondly, the detailed calculation for the strike price of the option appears to be reasonable because it is calculated after incorporating several factors.

As mentioned earlier, the volatility used might not reflect the suitable volatility, which should be used to calculate the value of option, the life used should be realistic and should be based on reasonable estimations. The profits that would be available from project and the life cycle of profits. After that, ten years life can be used in a Black Scholes model for the computation of option value.

The Black Sholes Model assumes that the project and the asset’s cash flows follow a lognormal distribution, similar to equity markets on which the model is based.Furthermore, the model also assumes that the value close to current market value of channel is the sign that The Black Sholes Model does not provide a correct value. It instead provides an indicative value that can be attached to the flexibility of a choice for possible future actions that may be embedded within a project.

Table 1.3

Input Data
Stock Price now (P) 23.15
Exercise Price of Option (EX) 1.22
Number of periods to Exercise in years (t) 10
Compounded Risk-Free Interest Rate (RF) 5.25%
volatility annualized 50.00%
Output Data
Present Value of Exercise Price (PV(EX)) 0.7217
*t^.5 1.5811
d1 2.9840
d2 1.4029
Delta N(d1) Normal Cumulative Density Function 0.9986
Bank Loan  N(d2)*PV(EX) 0.6637
Value of Call $22.45
Current market value per channel $23.15
25% volatility gives the value of call $22.43

Critical Investment Recommendation:

The Cox communication valuation seems slightly undervalued, especially when compared with the alternative terminal values and new equity values that are computed using different assumptions like growth rates and tax deduction to arrive at cash flows and to the valuation under different methods. After adjusting these rates with Martin’s estimates, we can find the same value.

The point is the value of Cox Communications seems undervalued and it is a good factor, as buyer can come up with the price to buy this company and later, it can exploit the hidden value of the company in a profitable manner.Therefore,it would be wiser for any buyer to do some kind of work on Martin’s estimates before making any investment decisions. The financial position of the company seems good as after incorporating new growth rates the free cash flows of the company are showing positive change............


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